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22-1IntroductionRich and poor countriesCharacteristics of poor countriesBorrowing and debt in developing economiesInternational Capital MarketsTypes of financial capitalLatin American,East Asian and Russian crisesLessons from crises and potential reformsReference:P.Krugman and M.Obstfeld,International Economics,Ch.212TerminologyEmerging markets:developing countries with liberalised markets and minimal state interventionReal interest rates=nominal interest rates inflatione.g.Real deposit rates(2%)=nominal deposit rates(5%)inflation(3%)Opportunity cost:interest foregone e.g.cash 100 in your hands for one year.The opportunity cost is interest,say 5 with 5%p.a.bank deposit rate.22-322-422-522-6Overview of World Economy1.Some countries have grown rapidly since 1960,but others have stagnated and remained poor.2.Many poor countries have extensive government control of the economy,unsustainable fiscal and monetary policies,lack of financial markets,weak enforcement of economic laws,a large amount of corruption and low levels of education.22-7Rich and PoorLow income:most sub-Saharan Africa,India,PakistanLower-middle income:China,former Soviet Union,CaribbeanUpper-middle income:Brazil,Mexico,Saudi Arabia,Malaysia,South Africa,Czech RepublicHigh income:US,France,Japan,Singapore,KuwaitIndicators of Economic Welfare for 4 groups of countries,2003GNP per capita(1995 US$)Life expectancyLow income45058Lower-middle income148069Upper-middle income534073High income2885078Source:World Bank,World Development Report 2004/200522-8Rich and Poor(cont.)While some previously middle and low income countries economies have grown faster than high income countries,and thus have“caught up”with high income countries,others have languished.The income levels of high income countries and some middle income and low income countries have converged.But the some of the poorest countries have had the lowest growth rates.22-9Rich and Poor(cont.)GDP per capita (1996 US$)annual growth rateCountry196020001960-2000 averageUnited States12414333082.5Canada10419269222.4Hong Kong3047267035.6Ireland5208263794.1Singapore2280249396.9Japan4657246724.3Sweden10112236622.1France7860223712.6United Kingdom9682221882.1Italy6817217942.9Spain4693180543.4Taiwan1468170566.7South Korea1571158816.0Argentina7395109951.022-10Rich and Poor(cont.)GDP per capita (1996 US$)annual growth rateCountry196020001960-2000 averageMalaysia214799373.9Chile381899202.4Mexico397087662.0Brazil239571852.8Thailand112168574.6Venezuela77516420-0.5Colombia252553801.9Paraguay243746821.6Peru311845831.0China68537474.3Senegal18331622-0.3Ghana83213491.2Kenya78012441.2Nigeria1035713-0.9Source:Alan Heston,Robert Summers and Bettina Aten,Penn World Table Version 6.122-11Rich and Poor(cont.)Poor countries have not grown faster:growth rates relative to per capita GDP in 196022-12Characteristics of Poor CountriesWhat causes poverty?A difficult question,but low income countries have at least some of following characteristics,which could contribute to poverty:1.Government control of the economyRestrictions on trade and financial repressionDirect control of production in industries and a high level of government purchases relative to GNPDirect control of financial transactionsReduced competition reduces innovation;lack of market prices prevents efficient allocation of resources.22-13Characteristics of Poor Countries(cont.)2.Unsustainable macroeconomic polices which cause high inflation and unstable output and employmentIf governments can not pay for debts through taxes,they can print money to finance debts.Seignoirage is paying for real goods and services by printing money.Seignoirage generally leads to high inflation.High inflation reduces the real value of debt that the government has to repay and acts as a“tax”on lenders.High and variable inflation is costly to society;unstable output and employment is also costly.22-14Characteristics of Poor Countries(cont.)3.Lack of financial markets that allow transfer of funds from savers to borrowers4.Weak enforcement of economic laws and regulationsWeak enforcement of property rights makes investors less willing to engage in investment activities and makes savers less willing to lend to investors/borrowers.Weak enforcement of bankruptcy laws and loan contracts makes savers less willing to lend to borrowers/investors.Weak enforcement of tax laws makes collection of tax revenues more difficult,making seignoirage necessary(see 2)and makes tax evasion a problem(see 5).22-15Characteristics of Poor Countries(cont.)Weak of enforcement of banking and financial regulations(e.g.,lack of examinations,asset restrictions,capital requirements)causes banks and firms to engage in risky or even fraudulent activities and makes savers less willing to lend to these institutions.A lack of monitoring causes a lack of transparency(a lack of information).Moral hazard:a hazard that a borrower(e.g.,bank or firm)will engage in activities that are undesirable(e.g.,risky investment,fraudulent activities)from the less informed lenders point of view.22-16Characteristics of Poor Countries(cont.)5.A large underground economy relative to official GDP and a large amount of corruptionBecause of government control of the economy(see 1)and weak enforcement of economic laws and regulations(see 4),underground economies and corruption flourish.6.Low measures of literacy,numeracy,and other measures of education and training:low levels of human capitalHuman capital makes workers more productive.22-17Characteristics of Poor Countries(cont.)22-18Borrowing and Debt in Developing EconomiesAnother common characteristic for many middle income and low income countries is that they have borrowed extensively from foreign countries.Financial capital flows from foreign countries are able to finance investment projects,eventually leading to higher production and consumption.But some investment projects fail and other borrowed funds are used primarily for consumption purposes.Some countries have defaulted on their foreign debts when the domestic economy stagnated or during financial crises.22-19Borrowing and Debt in Developing Economies(cont.)national saving investment=the current account where the current account is approximately equal to the value of exports minus the value of importsCountries with national saving less than domestic investment will have a financial capital inflows and negative current account(a trade deficit).22-20Borrowing and Debt in Developing Economies(cont.)Current account balances of major oil exporters,other developing countries and high income countries,1973-2003 in billions of US$Major oil exportersOther developing countriesHigh income countries1973-1981363.8-410.07.31982-1989-135.3-159.2-361.11990-1997-73.9-600.179.01998-2003236.5-12.8-1344.3Source:IMF,World Economic Outlook,various issues22-21Borrowing and Debt in Developing Economies(cont.)A financial crisis may involve1.a debt crisis:an inability to repay government debt or private sector debt.2.a balance of payments crisis under a fixed exchange rate system.3.a banking crisis:bankruptcy and other problems for private sector banks.22-22Borrowing and Debt in Developing Economies(cont.)A debt crisis in which governments default on their debt can be a self-fulfilling mechanism.Fear of default reduces financial capital inflows and increases financial capital outflows(capital flight),decreasing investment and increasing interest rates,leading to low aggregate demand,output and income.Financial capital outflows must be matched with an increase in net exports or a decrease in official international reserves in order to pay people who desire foreign funds.22-23Borrowing and Debt in Developing Economies(cont.)Otherwise,the country can not afford to pay people who want to remove their funds from the domestic economy.The domestic government may have no choice but to default on its sovereign debt when it comes due and investors are unwilling to re-invest.22-24Borrowing and Debt in Developing Economies(cont.)In general,a debt crisis causes low income and high interest rates,which makes sovereign(government)and private sector debt even harder to repay.High interest rates cause high interest payments for both the government and the private sector.Low income causes low tax revenue for the government.Low income makes private loans harder to repay:the default rate for private banks increases,which may lead to increased bankruptcy.22-25Borrowing and Debt in Developing Economies(cont.)If the central bank tries to fix the exchange rate,a balance of payment crisis may result with a debt crisis.Official international reserves may quickly be depleted,forcing the central bank to abandon the fixed exchange rate.A banking crisis may result with a debt crisis.High default rates may increase bankruptcy.If depositors fear bankruptcy due to possible devaluation of the currency or default on government debt(assets for banks),then they will quickly withdraw funds(and possibly purchase foreign assets),leading to bankruptcy.22-26Borrowing and Debt in Developing Economies(cont.)A debt crisis,a balance of payments crisis and a banking crisis can occur together,and each can make the other worse.Each can cause aggregate demand,output and employment to fall(further).If people expect a default on sovereign debt,a currency devaluation,or bankruptcy of private banks,each can occur,and each can lead to another.22-27The Problem of“Original Sin”When developing economies borrow in international financial capital markets,the debt is almost always denominated in US$,yen,euros:“original sin”.The debt of the US,Japan and European countries is also mostly denominated in their respective currencies.When a depreciation of domestic currencies occurs in the US,Japan or European countries,liabilities(debt)which are denominated in domestic currencies do not increase,but the value of foreign assets does increase.A devaluation of the domestic currency causes an increase in net foreign wealth.22-28The Problem of“Original Sin”(cont.)When a depreciation/devaluation of domestic currencies occurs in developing economies,the value of their liabilities(debt)rises because their liabilities are denominated in foreign currencies.A fall in demand for domestic products causes a depreciation/devaluation of the domestic currency and causes a decrease in net foreign wealth if assets are denominated in domestic currencies.A situation of“negative insurance”against a fall in aggregate demand.22-29Types of Financial Capital1.Bond finance:government or commercial bonds are sold to private foreign citizens.2.Bank finance:commercial banks lend to foreign governments or foreign businesses.3.Official lending:the World Bank or Inter-American Development Bank or other official agencies lend to governments.Sometimes these loans are made on a“concessional”or favorable basis,in which the interest rate is low.22-30Types of Financial Capital(cont.)4.Foreign direct investment:a foreign firm directly acquires or expands operations in a subsidiary firm.A purchase by Ford of a subsidiary firm in Mexico is classified as foreign direct investment.5.Portfolio equity investment:a foreign investor purchases equity(stock)for his portfolio.Privatization of government owned firms has occurred in many countries,and private investors have bought stock in such firms.22-31Types of Financial Capital(cont.)Debt finance includes bond finance,bank finance and official lending.Equity finance includes direct investment and portfolio equity investment.While debt finance requires fixed payments regardless of the state of the economy,the value of equity finance fluctuates depending on aggregate demand and output.22-32Latin American Financial CrisesIn the 1980s,high interest rates and an appreciation of the US dollar,caused the burden of dollar denominated debts in Argentina,Mexico,Brazil and Chile to increase drastically.A worldwide recession and a fall in many commodity prices also hurt export sectors in these countries.In August 1982,Mexico announced that it could not repay its debts,mostly to private banks.22-33Latin American Financial Crises(cont.)The US government insisted that the private banks reschedule the debts,and in 1989 Mexico was able to achieve:a reduction in the interest rate,an extension of the repayment perioda reduction in the principal by 12%Brazil,Argentina and other countries were also allowed to reschedule their debts with private banks after they defaulted.22-34Latin American Financial Crises(cont.)The Mexican government implemented several reforms due to the crisis.Starting in 1987,It reduced government deficits.It reduced production in the public sector(including banking)by privatizing industries.It reduced barriers to trade.It maintained an adjustable fixed exchange rate(“crawling peg”)until 1994 to help curb inflation.22-35Latin American Financial Crises(cont.)It extended credit to newly privatized banks with loan losses.Losses were a problem due to weak enforcement or lack of accounting standards like asset restrictions and capital requirements.Political instability and the banks loan defaults contributed to another crisis in 1994,after which the Mexican government allowed the value of the peso to fluctuate.22-36Latin American Financial Crises(cont.)Staring in 1991,Argentina carried out similar reforms:It reduced government deficits.It reduced production in the public sector by privatizing industries.It reduced barriers to trade.It enacted tax reforms to increase tax revenues.It enacted the Convertibility Law,which required that each peso be backed with 1 US dollar,and it fixed the exchange rate to 1 peso per US dollar.22-37Latin American Financial Crises(cont.)Because the central bank was not allowed to print more pesos without have more dollar reserves,inflation slowed dramatically.Yet inflation was about 5%per annum,faster than US inflation,so that the price/value of Argentinean goods appreciated relative to US and other foreign goods.Due to the relatively rapid peso price increases,markets began to speculate about a peso devaluation.A global recession in 2001 further reduced the demand for Argentinean goods and currency.22-38Latin American Financial Crises(cont.)Maintaining the fixed exchange rate was costly because high interest rates were needed to attract investors,further reducing investment and consumption demand,output and employment.As incomes fell,tax revenues fell and government spending rose,contributing to further peso inflation.22-39Latin American Financial Crises(cont.)Argentina tried to uphold the fixed exchange rate,but the government devalued the peso in 2001 and shortly thereafter allowed its value to fluctuate.It also defaulted on its debt in December 2001 because of the unwillingness of investors to re-invest when the debt was due.22-40Latin American Financial Crises(cont.)Brazil carried out similar reforms in the 1980s and 1990s:It reduced production in the public sector by privatizing industries.It reduced
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